Altman Z System: Financial Ratio To Forecast Bankruptcy

We have seen many financial ratios that are able to dissect the health of a company in the various segments of liquidity, profitability, efficiency of assets, returns on assets or equity. But, I believe quite a few financial executives have yet to hear of one which can predict the probability of a company entering bankruptcy within a 2 year period.

Today’s discussion is on such a financial ratio. That ratio is the Altman Z System. This powerful diagnostic tool uses almost the same type of financial ratio we used.

Introduction to Altman Z System:
The person who discovered this “system” is Mr. Edward Altman, who is an economist. Yes, an economist! Not surprisingly to say that as econometrics is a very advanced study of mathematics and is part of the study of Economics.
He was able to use computer simulations to study companies, in order to come up with his Z-Score Formula for Predicting Bankruptcy. The system is about 72% – 80% accurate.

It combines five (5) common business ratios, using a weightage system designed by Altman. It was originally derived based on data from manufacturing firms but this has been modified for firms in general.

Appended below are the various formulas for Altman Z-Score System:
• Formula Altman Z-Score: (PUBLIC COMPANIES)

• Working Capital X 1.2
Total Assets

• Retained Earnings X 1.4
Total Assets

• Earnings be interest & tax X 3.3
Total Assets

• Market Value of Equity X 0.6
Total Liabilities

• Sales X 0.999
Total Assets

Original Z-score for PUBLIC MANUFACTURER
3 Or > Bankruptcy is not likely
1.8 Or > Bankruptcy is likely
(Between 1.8 to 3.0 – is the gray area )
Probabilities of bankruptcy within the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE MANUFACTURER
2.90 or > Bankruptcy is not likely
1.23 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE GENERAL FIRM / NON MANUFACTURER
2.60 or > Bankruptcy is not likely
1.10 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

• Formula Altman Z-Score: (PRIVATE COMPANIES)

• Working Capital X 0.717
Total Assets

• Retained Earnings X 0.847
Total Assets

• Earnings be interest & tax X 3.107
Total Assets

• Market Value of Equity X 0.420
Total Liabilities

• Sales X 0.998
Total Assets